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Choosing the Right Business Entity at the Federal and State Level
As a business owner, it’s important to understand the differences between various business entities. Some of the differences include how the entity is structured, how it’s taxed, and what kind of liability protection if offers its owners.
Another difference that’s often overlooked is whether the entity is defined at the federal level or the state level. For instance, the corporation, partnership, and sole proprietorship are defined by the IRS at the federal level. The limited liability company, on the other hand, exists because of state statute. It’s treated as a corporation, partnership, or disregarded entity by the IRS for federal tax purposes.
Some entities look so similar at first glance, it can be hard to see the distinction between a business entity defined at the federal level and one at the state level. One example of this is the S-Corp versus the statutory close corporation.
Case in Point: Pertuis vs Front Roe
Even the Supreme Court of South Carolina failed to make the distinction between state and federal statute in a recent decision filed in July, 2018, Pertuis vs. Front Roe Restaurants, Inc.
In short, Kyle Pertuis was the manager of three restaurants owned by three separate S-Corporations: Lake Point and Beachfront, both in North Carolina, and Front Roe, in South Carolina. All three S-Corporations were owned by Mark and Larkin Hammond. After working with the Hammonds for several years, Pertuis decided to leave, and this case is primarily about his ownership in the three restaurants and their valuation.
That’s not relevant to our discussion here, but what is relevant is the South Carolina Supreme Court’s assessment of whether the three S-Corporations should be amalgamated into a single entity or not. If yes, that means the three would be considered together as if they were one company. If no, the three should continue to be considered as three distinct businesses.
The Trial Court said yes, the three should be amalgamated, citing in part the fact that the Hammonds had “disregarded corporate formalities” including shareholder and board of director meetings. The Supreme Court said the trial court erred, because it overlooked the fact that all three companies were S-Corporations, which are statutorily permitted to disregard various corporate formalities including those of having shareholder and board of director meetings. The Court cites SC Code Section 33 Chapter 18, -200, -210, -220, and -230 to make these points.
But here’s where the Supreme Court erred: it failed to make a distinction between an S-Corporation (federal) and a statutory close corporation (state). The SC Code it cited is about statutory close corporations, not about S-Corporations.
S-Corporation Versus Statutory Close Corporation
An S-Corporation is a business entity that is defined by the IRS. A statutory close corporation is a business entity allowed by some states, including South Carolina.
An S-Corporation is a business entity with shares and shareholders, just like a C-Corporation. Certain entities may elect to become an S-Corp by filing Form 2553 with the IRS. Unlike a C-Corp, S-Corp income, losses, deductions, and credits “pass through” to shareholders, who pay taxes on the income (or deduct the losses) on their individual federal income tax returns. This is the biggest advantage of the S-Corp and why many businesses elect to become one – to avoid the “double taxation” of the C-Corp. (Read more on C-Corp versus S-Corp here on this blog.)
Statutory Close Corporation
A statutory close corporation is a type of corporation that is defined by state statute. A “close” corporation is typically one where the shareholders are actively involved in managing the business. Not all states allow for statutory close corporations, but South Carolina does. Any corporation in South Carolina with one or more shareholder may elect statutory close corporation status by filing with the South Carolina Secretary of State.
The main reason corporations in the state elect statutory close corporation status is because it offers business owners greater freedom from corporate formalities and greater organizational flexibility than does a standard corporation.
Some provisions to ease the formalities are automatically put in place for your business once the election is made to statutory close corporation status. Other provisions are only put in place if those incorporating make an affirmative selection. These may be made by checking the appropriate boxes on the form articles. Lastly, business owners also have the option to have documents laying out management, elimination of by-laws, dissolution rights, and buy-sell provisions.
The election of filing for a statutory close corporation at the state level does not affect how the corporation is taxed at the federal level. An important thing to note is that the statutory close corporation is automatically taxed as a C-Corp unless it makes the election to be taxed as an S-Corp.
Corporations that elect statutory close corporation status find that under these less rigid rules, they can operate more like a partnership, with greater organizational flexibility and freedom from standard corporate formalities.
Understand How the Law Affects Your Business: Work with Business Attorney Gem McDowell
Choosing the right entity and structure for your business may be more complex than simply deciding on LLC or corporation or partnership. By not understanding the difference between federal and state levels of business entities, and what options are available to you, you could be missing out on some great advantages in your business.
For a better understanding of your options, or for help drafting contracts and corporate governance documents, call Gem and his associatess at Gem McDowell Law Group in Mt. Pleasant, SC. Schedule an initial consultation by calling 843-284-1021 today.